What is it about?
Which shock triggers a currency crisis: a productivity shock in the real sector or a country risk premium shock in the financial markets? Which shock leads to a more severe currency crisis? Does each shock have a different probability of a currency crisis if the country has a different exchange rate policy? Do capital control policies have different effects on different types of shocks that trigger currency crises? We analyze the relationships among shocks, exchange rate regimes, and capital controls in relation to the probabilities of currency crises. Based on the theoretical model, we use panel data on 34 developing countries and apply a probit estimation.
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Why is it important?
It is important to answer these questions empirically because if different shocks have different probabilities of currency crises, we must consider the source of shocks when we formulate macroeconomic policies to prevent crises. First, we found that both country risk premium shocks and productivity shocks can trigger currency crises. Second, productivity shocks are found to be important triggers for severe currency crises, and this result is robust to exchange rate regimes. Third, we found that the floating exchange rate regimes are more vulnerable to shocks that trigger currency crises. Fourth, our results show that monetary tightening in pegged exchange rate regimes can increase the probability of currency crises. Fifth, we also found some evidence that capital controls can mitigate the impacts of productivity shocks in pegged exchange rate regimes.
Perspectives
Our first two results produce the following main policy implications; policymakers need to focus not only on the financial supervision and macroprudential policies to prepare a safety net against financial shocks but also on economic and industrial policies to avoid severe currency crises because we found that real (productivity) shocks trigger severe crises. For instance, various market regulations and structural reforms can influence innovations, as well as exits and entries of firms, and thereby change productivity dynamics. From the perspective of monetary policy formulation, our fourth result implies that an interest rate hike can send a negative signal to investors by indicating weak fundamentals or panic at the monetary authority, therefore evoking more speculative attacks and finally leading to a currency crisis. Our last finding supports the conventional view that pegged exchange rate regimes under liberalized capital accounts increase the risk of currency crises. A possible interpretation is that capital controls can insulate the economy from volatile capital, and hence the resilience of the economy increases during the time when the country is hit by the shocks.
Dr. Ryota Nakatani
International Monetary Fund
Read the Original
This page is a summary of: Real and financial shocks, exchange rate regimes and the probability of a currency crisis, Journal of Policy Modeling, January 2018, Elsevier,
DOI: 10.1016/j.jpolmod.2017.10.004.
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